4 >   Stick With the Folding Tables

After a year and a half in my basement, it was time to move my software business to an office. Though it would cost more, it would protect the privacy of my wife and kids, and create a healthy separation between work life and home life.

We lived in the country, near Piper City, a small town of just 800 people, a grain elevator, and a main street business district that’s just one block long. Decades ago those main street buildings housed a bank, a car dealership, a barbershop, a furniture store, and more. Some of the residents and leaders of the town didn’t want to admit it, but most of that was long gone and wasn’t coming back. Some of the buildings were vacant, some were in use, but none were in their prime.

I called the mayor and asked him if he knew of some office space available to rent. He put me in touch with a couple of building owners, and I worked out a deal with one of them to rent the front half of 15 W. Main St. It was one big room of about 2,500 square feet. It had been a construction office, a small engine repair shop, a pool hall, a dress shop, a furniture store, and probably some other things. Now it was about to become a software office. I and my employee had two 6-foot folding tables, our computers, and our office chairs. We set those up by the front door, and we were moved in. Our setup took up less than one-twelfth of the space we had rented.

Ten years later, I own that building, and three others on the same side of Main Street. At my companies, we aren’t in the software business anymore, but dozens of employees work there, doing 5,000 percent more business than we were doing when we moved in. A few years ago we converted the second story of 15 W. Main from a dusty attic, untouched for generations, to an additional floor of offices for our growing staff. One of those offices is mine, and in it stands one of those original folding tables. It’s still my desk.

Those expansions of our office space were productive investments in future business returns. They weren’t risky speculation. We had the sales and earnings growth to prove we’d need the space and make a profit on it.

Having more office space increased future returns, but upgrading my office furniture wouldn’t have. Can I afford new office furniture? Sure. I haven’t upgraded from the folding table because that would be consumption, not investment. I see neither emotional nor financial return from upgrading. Those businesses are Internet based. I don’t meet clients in that office. I have no visitors whom I need to impress. New office furniture wouldn’t do a thing to improve sales or earnings of those businesses, and it wouldn’t do a thing to improve my workday experience. I’m serious about evaluating the return on my resource-use decisions. I’m sticking with the folding tables.

See Consumption and Investment in Contrasting Colors

Consumption is trading resources for anything that doesn’t contribute to a future increase in your resources. Consumption may provide an immediate benefit, and that benefit comes at the cost of immediately and permanently reducing your resources.

Investment is trading part of your resources for something that does contribute to a future increase in your resources. It’s trading for something that, over time, is worth more than what it cost you. Something that provides a return.

Both consumption and investing use resources in the present. They each lead to very different results in the future. To be an effective investor of all your resources, you must not mix consumption and investment into a vague gray of “spending resources.” You must see them as polar opposites, like vividly contrasting colors.

Conrad and Ivanna are highly fictional characters stranded on a small, otherwise-uninhabited island.

They each have 24 hours of time per day to use as they choose. Drinkable water and adequate shelter are naturally available. They each need to eat five fish per day to survive for long. They want to use their resources to develop a way to get back to civilization and reunite with their families.

With immediate survival top of mind, they quickly discover how to catch fish by hand in the shallow water surrounding the island. It’s frustrating, it’s time-consuming, and it works. The first day they each catch five fish between sunup and sundown. They eat them raw, and retreat exhausted and sunburned to their shelter for the night.

As the sun rises the next morning, they wade out into the shallows to catch their meals. Again they each catch five fish, eat them raw, and sleep another night.

The next morning, Ivanna is bothered by the realization they are not getting ahead. They are spending all their time to produce resources and consuming them just to survive. As Conrad wades out to fish, Ivanna decides to use her time differently that day. With stomach growling she climbs up a hill to overlook the island and notes resources at hand. There are bushes, trees, rocks, a stream, sand, birds, and various grassy plants.

She gathers some thin branches and grassy reeds in a pile on a flat rock at the top of the island. She sits down and begins to braid the grasses into thin ropes. As she works she feels the discomfort of hunger, and sees Conrad on the beach below, eating a fish he just caught. He wades out to try to catch another, and she continues to use her time to braid dozens of long thin ropes.

As Conrad goes to sleep that night, Ivanna continues working by moonlight. As the sun rises he awakes to find her sleeping, with dozens of fish piled nearby. Amazed at her late-night fishing success, he wakes her to ask the source of this good fortune. He learns, as you have surely guessed, that she has built a fishing net. She can haul in 10 fish with about an hour’s work.

She limited her consumption and invested her time and a few natural resources in something that increases productivity.

That day they reach an agreement: Ivanna will rent Conrad her fishing net for a price of five fish per day, all she needs to survive. Conrad will fish one hour per day and catch 10 fish, enough to pay the rental fee and provide for his own survival.

Two days ago Ivanna had to work her entire day just to eat enough to survive. From now on she doesn’t have to spend any time at all on food for survival. Why? Because she limited her consumption, created a surplus of time for a day, and invested it to create something that pays back far more than it cost, day after day, for a long time.

What’s more, her investment in productivity was not at Conrad’s expense. If he was fishing 12 hours a day before, his agreement with Ivanna frees 11 hours of his time per day as well. Investment in productivity is not a zero-sum game.

Consumption and Investment Compete for the Same Resources

In their simple scenario, our castaways could use their time resource to get enough food for a day’s consumption, or they could invest their time resource in something of lasting value. Whatever time they spent fishing wasn’t available to invest, and whatever time they spent building nets wasn’t available for fishing.

The same is true for us in the real world. Real life contains a larger number of opportunities and greater complexity, but the principle is the same. Money spent on rent is no longer available to buy stocks or start a business. Two hours spent enjoying entertainment can’t also be spent creating a new product.

You get to decide how to divide your resources between consumption and investment. Take a vacation, or new equipment for your business? Bigger house payment, or bigger contribution to your retirement account?

Housing and transportation are the biggest consumption expenditures of American households (source: www.bls.gov/news.release/cesan.nr0.htm). The kind of house you live in and the kind of car you drive are likely a big portion of your total consumption. Consume too much of your resources on big items like these, and your investing hands will be tied. Frugality on the little things (skipping Starbucks, or cheaper office supplies) can’t overcome the headwinds of over-consuming on the big things (a big mortgage, or undisciplined labor costs).

Trading your time to simply consume more than you need to survive is a very expensive decision, especially early in life and when your resources are few. Most people in developed countries make this decision continuously throughout their lives. If you spend all your working life at a job, and consume (rather than invest) the entire proceeds of that job, you will never start the virtuous cycle of investment. The end result of that approach will be far fewer resources, and even far less opportunity to consume than through the alternate approach of limiting consumption in order to save and invest.

Limiting Consumption to Increase Investment Leads to Abundance

When you choose to limit consumption, as Ivanna did, and direct those resources to investment activity instead, you start a positive spiral of increased productivity and growing resources. Investments pay returns, increasing total resources. If those additional resources are invested, and not consumed, those new investments pay still more returns. This is the positive spiral of compounding. The long-term effect is a dramatic increase in resources.

Ivanna’s investment allowed much greater consumption in the future than if she had never been willing to be hungry for a little while. This happened quickly in our island story because the productivity gain from the fishing net was a huge 2,400 percent. Dramatic returns like this are possible in the real world too, but often investment returns are much lower. Even with a modest 10-percent gain from investing resources, savers still pull ahead of consumers over time.

Consider a frugal saver who limits her consumption to 70 percent of her total income, and invests the other 30 percent at a 10-percent after-tax annual return. (Stocks and bonds would likely return less than that. If she invested where she had an advantage, such as a certain business, her returns would likely be much more.) For the first 13 years she would consume less than a neighbor with the same income who consumed 100 percent of his income. Looking over the fence at her neighbor’s superior lifestyle could make it hard to believe that her decision to consume less and invest more was a wise choice.

She would have the equivalent of four years’ income in savings at 13 years; maybe that would be some consolation.

For all years following, she would be consuming more than her non-saving neighbor, and still investing 30 percent of her total income each year. Fifty years after beginning this program, she would be able to consume three times what her neighbor was consuming each year, and she’d have 34 years’ worth of income in savings. He’d have none. By this time the benefits of her early-years choice to limit her consumption would be obvious. If around the time it became obvious, her neighbor started looking over the fence and wondering about his 100-percent-consumption choice, it would be too late for him ever to catch up to his frugal neighbor.

If our frugal saver limited her consumption to 50 percent of her income, and invested the other 50 percent, her consumption would catch up to her non-saving neighbor in just nine years. See the link at the end of this chapter to download a spreadsheet and experiment with the actual numbers from this example.

One of the most powerful things you can do for your financial future is consume less in the present, and invest more for the long term. This willingness to limit present consumption in order to produce a large investable surplus makes the difference between a lifetime of treading water, and a future of growing resources.

At the time of this writing (2015), the average American spends 95 percent of their income on consumption, leaving just 5% for investment (source: https://research.stlouisfed.org/fred2/data/PSAVERT.txt). If you choose to limit present consumption in order to save and invest a much higher percentage than that, you won’t have to move the consumption setting many notches to come out far ahead of your American neighbors.

Survival Demands a Base Level of Consumption (and Cash)

Unfortunately, reality doesn’t let enthusiastic savers take this concept of limiting consumption to the extreme. If you consume nothing, and invest 100 percent of your resources, you’ll starve to death. If at any point you don’t survive, the rest of your time—your most precious resource—will be forfeited.

Your survival requires air, water, food, shelter, mental health, and maybe some other things. Your first and permanent baseline task is to ensure your resources are sufficient to provide for your survival. Only when you have surplus resources (those resources not needed for your survival) can you decide to invest, or do anything other than survive.

In the beginning, you’ll probably need to trade your time for resources, and consume them in order to survive. This means produce them directly, or work for money to get the water, food, and shelter you need to survive. In developing countries this might be subsistence farming or working for day wages. In developed economies this usually means having a job. A job consumes a great deal of time, and this usage of your most precious resource should not be taken lightly. The key is to limit your consumption and thereby create an investable surplus as soon as possible.

In business, cash is oxygen. Run out of it, and you’ll be dead in short order. A bottle of oxygen won’t help if it’s an hour late, and extra cash next year won’t help a business stay alive either. It’s impossible to make decisions for your long term while gasping for air. When survival is in question, survival naturally and necessarily becomes top of mind. The only way to avoid this is to produce more than you consume, and save a surplus. It’s much easier to think like an investor when you have extra cash on hand.

The same is true of personal life. Many households live paycheck to paycheck, and that situation forces decisions that produce short-term gain for long-term pain.

One of my business buildings sits next to a gas station. I’ve observed people who visit it multiple times per week, putting $5 of gas into their car at a time. My mind protests the time resource they spend driving there, filling up, paying, and driving off. I bet it amounts to 30 minutes a week for some people. Do that for a decade (as some do) and the total time cost is about 250 hours, equivalent to a month of full-time work. During that decade, I estimate our frequent-filler would also consume about 20 tanks of gas on the mile or two back and forth to the gas station. If this person generates enough surplus cash to invest in completely filling the tank just one time, no additional investment will be required ever to enjoy the time and fuel savings of minimizing trips to the gas station.

If our frequent-filler currently spends $15 per week on gas, then decides to invest in a complete fill, he’ll spend perhaps $50 that week on gas. For all weeks for the rest of time, his expense goes back to what it would have been ($15 not counting changes in gas prices).

This is an extreme example of making decisions to maximize immediate cash flow at the expense of long-term results. This is managing to cash flow instead of to maximum return. It’s a vicious cycle. If you are in it, do whatever it takes to generate a surplus that frees you from that cycle. You only have to do it once, for a lifetime of benefit.

When we are managing to cash flow instead of long-term results, we do things like habitually pay interest on credit card balances, take lower-paying work because it pays sooner, or repair a worn-out machine repeatedly to avoid the big cash outlay of replacing it. These may not be as obviously shortsighted as frequent trips to the gas station, but the principle and the results are the same.

Because cash is oxygen, credit cards or other convenient sources of borrowing might seem like a handy way to keep breathing when income and bank accounts run low. The long-term cost of using credit in this way is invisible at first, but soon creates a hole that’s expensive and difficult to climb out of. Except in emergencies, live within your means so you have extra cash in the present, and the freedom to do what’s best for your long term, even if it reduces your cash up-front.

I do not lack compassion for the survival pressures that frequent-fillers, and their equivalents in others areas of life, are dealing with. I earnestly long to see them make different investment decisions and escape the cycle of managing to cash flow. If they work a couple hours of overtime, or forego enough consumption to create just one tank of surplus, so to speak, they can permanently improve their situation. (So far no gas station patrons have asked my opinion, and I have refrained from leaning out of my office window to offer unsolicited advice.)

Focusing on long-term returns without concern about short-term survival is a luxury that’s available to many more people than are currently enjoying it. If you are an able person living in a country with a functioning economy, rule of law, and a few other essentials, you have the choice to consume less than you produce (or produce more than you consume) and create a surplus. Get ahead in this way just once, and you can ensure you won’t be distracted from good investment decisions by the need to gasp for air.

Delaying Consumption Is an Emotional Ability

In the Stanford marshmallow experiment, researchers placed a marshmallow in front of a child and offered a choice: Eat it now, or wait 15 minutes and get two marshmallows to eat. Children who waited longer for the greater reward, and thus accepted delayed gratification, had better long-term outcomes in life. They were more successful, and even took better care of their health than those children who shortchanged themselves because they couldn’t wait to consume the marshmallow.

The ability to delay gratification to get more of what you want in the long term sits at the core of sound investment thinking. Investment is all about accepting less now in order to have more later. If you consistently choose the path of delayed gratification for greater long-term return, you will do very, very well.

This isn’t easy. It can be truly uncomfortable, even painful, to delay gratification and invest in your future. Dieting and exercise, years of night school, attending psychotherapy, working two jobs, launching a business on a shoestring—these can be difficult short-term pains that lead to really big long-term gains.

It’s natural to feel a pang of loss or deprivation when saying no to consumption, and having to wait for something we want. Tell a small child they can have that delicious candy after dinner, and their frustration and disappointment may bring tears. Effective investors learn just the opposite emotional reaction. They smile like a baby with a lollipop when they get to invest resources for an abundant return in the distant future, and they feel like crying when they are forced to consume resources in the present that could have been invested. I think a rich imagination, a focus on the future, and a bent toward optimism enable investors to bring the emotion of the long-term results into their present decisions.

Fundamentally, delayed gratification requires a belief in abundance, and optimism about the future. It rests on a belief that there will be enough, that there will be more, that the consumption we forgo today won’t be lost to all time, and that the system works and the returns will come back to us.

Future-focused investors don’t feel deprived when conserving resources to invest; they feel deprived when consumption steals from their investment resource pool. I don’t go to bed at night feeling sad that I had to play for the long term instead of binging on consumption that day. I’m genuinely thrilled to get to play the game this way.

Limiting Consumption Does Not Mean Limiting Spending

Katie is a friend of mine who owns a growing business in the beauty industry. When we talked recently she was deciding whether or not to carry an entire product line from a major makeup manufacturer. She liked the quality, and her knowledge of her business provided a solid basis to believe the product would sell. If it sold well, it would produce a truly stellar return on her investment in initial inventory.

We worked through the numbers together, and there was no denying they looked good. Trouble was, the manufacturer required a big up-front purchase. The size of the check she’d have to write made her nervous. I think she was wise to consider carefully before spending such a large amount of cash.

We talked about the difference between spending that amount of money on consumption and spending that amount of money on a stellar investment opportunity like this product line. Stretching to spend a lot of money on a great investment is a good move. Stretching to spend a lot of money on a shopping spree or other consumption is a very bad move. The two are opposites. Katie saw this clearly, and she chose to spend that cash on that big investment. It still felt like a big risk, but her clarity about consumption versus investment allowed her to make an intentional choice rather than an emotional one.

I know a lot of people who grew up in families that valued frugality and taught their kids to limit spending. Many of these families were frugal and responsible consumers of their income, and not active as long-term financial investors. As a result, those children-turned-adults carry an internal compass that warns against spending a lot of money. Unfortunately, that type of internal compass tends to point to “spend less” no matter which direction its bearer is facing. A better compass points to maximum return instead.

Here’s an extreme example. Imagine a farmer who limits spending on seed in order to save money. As a result he plants only half his acreage in crops. Of course he doesn’t end up “saving money” at all, because he eliminates half of his farm income that year by limiting his spending. He was limiting investment, not consumption.

Of course no farmer in the real world would be so shortsighted. The business owner that limits spending on a needed expansion, the family that limits spending on retirement investments, and the student that limits spending on learning resources are all making a decision to limit investment. It’s not as obvious as the farmer who plants half his crop, but the principle and the results are the same.

From time to time I remind the managers who run my businesses that I am eager to spend money—when it’s an investment that pays a good return. Because we have limited consumption and created a cash surplus from the beginning, we don’t need or want to conserve cash. We want to hunt for investments that pay a good return, then quickly and happily write checks for those investments. Expensive factory equipment that will earn back its value in two years? Yes, please—sign me up.

Investors see consumption and investment in contrasting colors. They learn to cringe when they write a big check for consumption, and rejoice when they write a big check for investment. They don’t operate on a simple rule of “spend less.” They stretch to spend less on consumption, and more on investment.

Be Frugal About the Right Things

By limiting your consumption and investing more, you’ll be directing your resources to where they can grow. When making financial investments, watch out for investing expenses that, ironically, can consume a significant slice of your returns. Perhaps consumptive expenses seem out of place in the world of investment, but I assure you that Wall Street is not populated by charitable organizations. They earn fees and commissions in a number of ways. It’s their right to do business in those ways, and it’s your right to avoid nearly all of those expenses.

When you buy or sell a stock or bond through a financial broker, you’ll pay a commission on each transaction. Major online brokers currently charge about $7 to $10 per trade. When investing small amounts of money—say $1,000 at a time—this amounts to about 1 percent of your investment on the buying end, and another 1 percent if you sell the investment soon after. Active traders who frequently buy and sell tend to earn about the same returns as the average investor, before commissions, and a little less after paying those commissions. You can avoid paying much commission at all if you make few transactions, and hold on to your financial investments for a long time. Whether or not that’s your strategy, be aware of the commissions you’re paying every time you buy or sell.

Be even more wary of paying anyone a fee to manage your investments. In the typical arrangement, the investment manager takes a fee of 1 percent of the value of the investments they are managing for you. They take this fee every year, so they make money whether you did or not. Stock markets have returned about 5 to 10 percent per year on average. If your wealth manager takes a 1-percent fee, they are taking 10 to 20 percent of your gains each year, even though you are taking 100 percent of the risk and providing 100 percent of the capital. Due to the exponential effects of compounding, this can reduce your total investment returns by one-third or more over the course of a lifetime.

Theoretically, they are making investment decisions that produce above-average returns for you, but it’s mathematically impossible for them all to be above average. Very few asset managers have a genuine advantage over the rest of the market, though some are lucky for a few years. If they make investment decisions that produce below-average returns for your investments, they still take their 1-percent fee.

Also be careful about mutual fund fees. Many mutual funds do something like the investment managers we just talked about. They pay a professional manager to manage the fund, and that and other expenses typically add up to 0.5 to 1 percent of the fund’s assets every year. Mutual funds provide a valuable service by allowing you to own part of a broad pool of investments, thereby increasing your diversification. However, some funds’ fees are much higher than others. It pays to shop around and pay attention to fees, to minimize the costly drag on your total returns.

You can get almost exactly average returns by investing in index funds that own a little of everything. Some index funds that track the broad stock market charge fees as low as 0.1 percent. Using index finds you’ll probably beat most mutual funds, and pay much lower fees.

Do limit your consumption. Don’t be stingy with your investment budget. Do be stingy with your investment expenses.

Beware Sunk Costs

There’s another common fallacy that sometimes comes under the heading of saving money. Though intended to avoid waste, erroneous thinking about sunk costs often leads to poor decisions.

Sunk costs are resources already spent, that you won’t get back no matter which path forward you choose. Here’s an example.

If you invest four years of time and $100,000 in a college degree in one career, then discover that career pays less and is less enjoyable for you than another career choice, should you switch? Should the fact that you’ve invested so much in that degree have any bearing on the decision?

Intuitively most of us want to say yes, because it’s so disappointing to “waste” the investment of four years and $100,000 by switching careers. That $100,000 investment is a sunk cost, and economists look at it this way. If the first career will pay $200,000 less over a lifetime than the second career, then sticking with the first career will cost $200,000 more than dropping it now and switching to the second. The $100,000 expense for completed college cost isn’t recovered in either scenario, so it should not influence the decision. Only the difference between the two scenarios, going forward, is relevant.

In one of my businesses we recently spent more than $2,000 to replace the radiator and the exhaust on a forklift. As soon as those repairs were completed, we discovered that the same forklift also needed an expensive new carburetor. The $2,000 already spent plus the cost of the carburetor replacement added up more than the forklift was worth. Did that mean we should stop spending money on repairs and buy a new forklift? No. The $2,000 was a sunk cost. Whether we completed additional repairs, or junked the forklift, we would not get the $2,000 back. If we had known about the carburetor repair before we repaired the radiator and the exhaust, we would have decided to junk the forklift. Once the $2,000 was spent however, it was no longer relevant to the decision.

The rational way to evaluate the carburetor decision, ignoring sunk costs, worked as shown in the table on page 68.

The $2,000 just spent on radiator and exhaust doesn’t factor into those calculations, because no matter what we decided to do at that point, it was already gone and not coming back. I’m happy for any chance to spend $1,200 for a $2,500 increase in value, so we replaced the carburetor.

Item	Amount
Cost of radiator repair (sunk cost):	$2,000
Value of forklift as it is now, with a broken carburetor:	$500
Value of forklift after carburetor replacement:	$3,000
Value increase from carburetor replacement ($3,000-$500):	$2,500
Cost of carburetor replacement:	$1,200
Gain on carburetor replacement:	$1,300

Say you buy an investment for $10,000, and the value drops to $8,000. If someone offers you $9,000 for that investment, should you sell for $1,000 less than you paid? It’s intuitive to resist, not wanting to take a $1,000 loss on the investment. Truth is, when the value dropped from $10,000 to $8,000, you already lost $2,000. That’s a sunk cost. When someone offers to buy it for $9,000, they are offering you a chance for a $1,000 gain, and you should probably take it. Like continuing to bet on a bad poker hand because you’ve already bet a lot, how much you “have in it” is irrelevant.

The same logic applies to years spent at a bad job, or in a bad relationship. Additional years of misery do nothing to redeem the years of misery already incurred. Two wrongs don’t make a right. Confront and make change, even when you have a lot invested in the way things are.

As relational beings, we are prone to get attached, and we are wired to resist accepting losses. Attachment to people is a healthy and essential part of being human. And still, some human relationships are worth ending.

Acting like you’re married to your investments is a big mistake. You’ll make better decisions when you see sunk costs for what they are, and leave them out of your investment decisions. You can’t change the past. Choose the option that will produce the best result from this moment forward.

Action Points

  See vivid contrast between consumption that reduces resources and investment that grows resources over time.

  With optimistic vision and future focus, develop gut-level positive emotion about investing resources, and resistance to future-robbing consumption.

  Do whatever it takes to create a surplus of cash and other resources so you can stop focusing on survival and prioritize long-term returns in your decisions.

  Spend little when the returns will be little. Spend a lot when the returns will be a lot. Limit consumption, but maximize investment.

  Be stingy about incurring trading commissions, asset management fees, and other investing expenses that threaten to skim away a huge slice of your returns over time.

Engage Online

Download a spreadsheet and experiment with how savers outpace consumers over time at www.aardsma.com/investingbook.